By William Isaac, Published by The Deal Magazine

Washington has been all atwitter the past couple of weeks about a “new” plan to purchase toxic assets from banks.

In reality, the plan is an old idea that should be rejected.

A bad-bank plan will be a horrendous waste of taxpayer money. Banks won’t sell bad loans except at a premium over what they can get in a private sector sale. Private sector investors won’t pay the government more than market prices for the assets. So taxpayers will buy high and sell low.

Moreover, while the assets are in government hands, their value will depreciate significantly. The rule of thumb at the Federal Deposit Insurance Corp. was that nonmarketable assets we inherited from failed banks depreciated by at least 25% from the value they would have had if they remained as a going concern. The banks know the borrowers and likely have multiple relationships with them, and the banks have the personnel and operating systems in place to work out the loans without interruption.

Further, there will be a huge temptation to politicize the collections process if the loans are in government hands. Politicians will clamor on behalf of their constituents for forbearance on some loans and continued funding on others. Trust me, those are decisions we want to leave with the banks, not the government.

Treasury originally proposed to buy bad assets when it asked for the bailout bill last fall. It shifted to a program to recapitalize the banks. That was the right strategy then and remains so today.

Banks are able to lend 7 to 10 times their capital, so a dollar of new capital creates up to $10 of new lending capacity. A dollar used to purchase a bad asset creates only $1 of new lending capacity.

A bad bank will almost certainly focus on a handful of large banks to the exclusion of the community banks which fund the small businesses that fuel economic growth. The capital purchase program benefits banks of all sizes.

Proponents of the bad bank argue that we have already put $300 billion of capital into the banking system, and lending remains sluggish. The solution to this problem is not to abandon a good program in favor of a bad one, but to make the good program better.

Banks have not been required to make new loans as a condition of receiving taxpayer capital (indeed, regulators are pressuring banks to reduce their loans and increase capital and reserves). Banks taking government capital should be required to make an appropriate commitment to increase lending if it can be done without undue risk to the bank.

The current capital program is not large enough. The capital infusions to date are less than half the amount of capital the Securities and Exchange Commission and the Financial Accounting Standards Board have destroyed through their application of mark-to-market accounting. We need more capital infusions, and we need to order the SEC and FASB to halt immediately their senseless destruction of bank capital.

Bank regulators have put in place highly pro-cyclical models for determining the adequacy of bank capital and loan loss reserves. The models require too little capital and reserves in good times and too much in bad times. We will have enormous difficulty escaping the downward economic spiral unless we abandon pro-cyclical accounting and regulatory policies.

Another major problem is that the securitization markets have dried up, which prevents banks from packaging new loans and selling them to investors. Rather than using scarce resources to purchase existing bad loans from banks, more dollars should be dedicated to offering, for a fee, carefully crafted government guarantees on securitized packages of new loans.

To date the government has been injecting capital into banks through preferred stock, due to concerns about investing alongside common shareholders and giving them a windfall. The markets, and the rating agencies, are clamoring for more common equity instead of more preferred stock.

So let’s have the option of the government investing in common equity on reasonable terms, with strong incentives for banks that raise private capital to match the public capital and-or retire the public capital at an early date. Shareholders of banks have already been punished severely, so let’s not worry about inflicting more pain on them.

If we make the changes outlined above, we will get the financial system turned around at little or no additional cost to taxpayers, which will give a much needed boost to the economy. If I were a betting man, I would wager that taxpayers will earn a positive return on their investment in the capital of banks.

William M. Isaac, former chairman of the Federal Deposit Insurance Corp., is chairman of the Secura Group of LECG, a financial services consulting firm based in Washington.